The new tax law's business impact - 1993 budget effect on business tax

Nation's Business, Oct, 1993 by Joan C. Szabo

Tom and Caroline Hoyt, owners of a small residential real estate company in Denver, expect to scale back their company's growth plans now that they must pay higher taxes under the recently enacted Omnibus Budget Reconciliation Act of 1993.

The biggest tax increase facing their 25-year-old firm, McStain Enterprises Inc., relates to the higher income tax rates enacted as part of the legislation, which the Clinton administration estimates will reduce federal deficits by $496 billion over five years.

The Hoyts' firm, like thousands of others, is organized as an S corporation, which means its profits are passed to its shareholders in proportion to their ownership of the firm. Thus, the profits are taxed at the new, higher individual rates.

This taxation provision is one of the characteristics that distinguish an S corporation from a regular corporation, which is subject to two levels of tax-one on earnings and another on dividends distributed to shareholders.

The higher individual tax rates will also affect partners and sole proprietors.

The new law creates a 36 percent rate for joint taxable income over $140,000 and single taxable income over $115,000. In addition, a surtax is imposed on taxable income over $250,000, which effectively raises the top individual tax rate to 39.6 percent from the previous level of 31 percent.

Because certain deductions and exemptions are reduced for individuals with high incomes, it is as if their top marginal rate exceeded 40percent.

The new law also raises the top corporate rate to 35 percent from 34 percent.

Although supporters of the personal income tax hike said it would affect only the wealthy, the income levels at which the new higher rates apply are not so large for growing small firms. "Our game plan was to build a strong equity base in the company," Tom Hoyt says. "We wanted to reduce debt. But the higher rates will delay our plan by about a year and a half." As a result, the Hoyts expect to pay more money to the federal government and invest less in their business.

"Paying higher taxes also will make us more susceptible to the next economic downturn because it will take the firm longer to build strength," Hoyt says.

Like the Hoyts' firm, an estimated 1 million companies--S corporations, partnerships, and sole proprietorships--will be subject to the higher individual rates. That is about 5 percent of the 21 million tax returns that include small-business income.

Many of these small companies organized or reorganized ass corporations when the 1986 tax-reform law was enacted. Under that law, individual tax rates were lower than corporate rates, which made it advantageous for a firm to be an S corporation because its profits would be subject to the lower personal rates.

At the same time, however, S corporation shareholders such as the Hoyts must pay taxes on their total profits, even though most such owners reinvest part of their profits in their businesses to keep them healthy and growing.

Tom Hoyt says he has considered switching to the status of a regular corporation--known as a C corporation-- but the S corporation has other benefits that must be considered. In general, say accountants, it still makes more sense to remain an S corporation even though some companies will be subject to higher tax rates. This is true, they say, because an S corporation pays only one level of tax, whereas dividends from a regular corporation are taxed twice--as profits to the company and as dividends to the shareholders.

In addition, the taxable gain after the sale of a business can be less for an S-corporation owner than for an owner selling a comparable C corporation.

Another disincentive to switching from S-corporation status is that a company that does so must wait five years before switching back.

A number of accountants and small-business owners say they understand Hoyt's dilemma. They say the higher individual tax rates are probably the most detrimental provision of the law for small firms organized as S corporations.

Thomas Brock, president of Brock & Co., a Longmont, Colo., accounting firm that has many small-business clients, says: "While the new law will have little effect on very small companies, the higher individual tax rates will be very hard on S corporations that are demonstrating strong growth and driving the economy"

Brock expects the higher rates to have a negative effect on overall business growth. For example, he says, "companies that will be subject to higher taxes won't expand as fast, won't pursue opportunities that they might have, and won't buy machinery or computer software that they expected to buy"

Small-business owner Jan E. Smith, president of Jan E. Smith & Co., a commercial real estate and business investment company in Bradenton, Fla., says he is especially concerned about the reduction in the deductibflity of business meals and entertainment. Smith buys and operates small businesses; his firms include several travel agencies and companies in the hospitality industry.

The new tax law trims the deductibility of business meals and entertainment from 80 percent to 50 percent starting in 1994. Smith is concerned that the change will have a severe impact on the hospitality industry. "There may be a number of jobs lost," he says.